Bond guru Kathleen Gaffney: it’s tough to find income in fixed income

There’s not a lot of income in fixed income these days, so active management of your bond portfolio is even more important, says Eaton Vance’s Kathleen Gaffney, one of Wall Street’s most astute fixed-income investors. So how are she and other active bond-fund managers generating returns?

During this week’s 70th annual CFA Institute conference, to be held Monday through Wednesday in Philadelphia, Gaffney, along with Vanguard founder John Bogle and Wharton School finance professor Jeremy Siegel, will share their thoughts on investment strategies in the current environment. (CFA, or chartered financial analyst, is considered to be one of the toughest designations to achieve. We lovingly refer to the CFA confab as a “nerdfest.”)

Eaton Vance Management’s Gaffney, a CFA charter holder, is codirector of investment-grade fixed income, and lead portfolio manager for Eaton Vance’s multisector bond strategies. She’s responsible for buy-and-sell decisions and portfolio construction. She joined Eaton Vance in 2012 after working for many years with Loomis Sayles bond guru Dan Fuss.

“It’s extremely hard to generate income now, and that’s exactly the time you don’t want to reach for yield,” Gaffney said. “That’s why active bond portfolio management becomes your most important defense in this frustrating environment.”

Sectors where yields – the income on a bond – are rising, she said, include retail companies, mall REITs, and telecommunications.

“The reason they yield so much is fundamentals are deteriorating, and investors are demanding more income. That can be a very tricky investment, because what’s the potential downside?”
Instead of Amazon or Apple, she buys bonds that have sold off sharply and offer value, such as Seagate Technology, a disk-drive manufacturer. “Seagate was a sleeper old-tech company that’s been through different cycles. We still need standard computer storage, and the more data out there, the more demand for Seagate.”

Gaffney bought the 10-year and the 30-year bonds when they were yielding 8 percent and trading around 70 cents on the dollar. “We’ve pared back,” she said, “because they’ve done very well.

“The great thing is, you have underlying asset value that minimizes the downside. To me, that total return is the way to manage fixed income,” meaning price appreciation plus a decent yield.

The Eaton Vance Multi-Sector Income Fund can hold a maximum of 35 percent of below-investment-grade bonds, as well as floating-rate bank loans and emerging-market dollar-pay corporate debt.

Interestingly, it doesn’t hold U.S. Treasuries.

“We don’t own them. The yields are low. Growth should pick up here in the U.S., but there’s tremendous uncertainty. The Fed can’t fix that, only politicians can.

“Today reminds me of the summer of 2014, as there doesn’t seem to be a lot of value. What’s different is the extremes we see in volatility,” particularly driven by politics in places such as Puerto Rico and Brazil.

“Politics are driving volatility, and the fact that expectations for economic growth and fiscal stimulus are now in doubt. I believe we will get there one way or another, but the election was tied to getting U.S. growth going,” she said, which has been sidetracked by recent White House turmoil.

Because short-term interest rates remain so low, “investors can’t earn money in the market, and yet we have this reach for yield, so every investment asset is overvalued or crowded.”

Gaffney believes bond investors plowing money into low-cost ETFs and index funds may beget disappointment because “everyone owns the same thing. When volatility picks up, a lot of funds have to reposition and sell. That can create a vicious negative feedback.”

As for Puerto Rico, “we expect a long-term workout, which is already priced into the bonds. We view the revenue bonds as more attractive.” Eaton Vance also owns Brazilian dollar-pay corporate bonds, as she believes Brazil is “turning the corner, but with a long path to where the country needs to be. Brazil is an excellent example of a country that benefited from investment-grade ratings.”

Gaffney holds such Brazilian corporate-bond names as energy giant Petrobras and JBS, a food manufacturer, which offer yields of 6.5 percent to 7.5 percent on bonds ranging from 10-year maturing in 2027 all the way out to 2043. Gaffney is also positioning for a turn in the U.S. dollar – which has been trading at a multiyear high against many currencies.

“We own the Brazilian government bonds, denominated in reals; Mexican government bonds, denominated in pesos; bonds payable in Indonesian rupiah and Indian rupees – these are countries on the path toward reforms. We’re likely to see their currencies benefit vs. the U.S. dollar,” she said.

“Our view is that the push for fiscal stimulus here means inflation, and nominal growth feels good if wages are moving up” at the same time.

Eaton Vance also expects that growth globally could lead to rising inflation in the United Kingdom, Germany, and China. “We’re likely to see a weaker yen, a stronger euro, and the U.S. dollar weaker relative to emerging markets,” Gaffney said.

Not surprisingly, Bogle will be talking about “the index revolution and what it means to professional investors, who are starting to think about asset allocation more and stock picking less. In some cases,

it’s gone too far. It used to be just stocks and bonds, and now it’s highly complex allocations based on data mining,” he said. “That’s not healthy.”

Given the flood of money into passive index funds, we asked Bogle: What happens if everyone invests using only index funds?

“There’s zero chance of that happening. Indexing represents 22 [percent] to 23 percent of the U.S. market. There’s just too much trading out there.”

For a list of CFA speakers, visit the conference website (annual.cfainstitute.org/speakers).